Share Options

A share call option gives the purchaser a right, but not the obligation, to buy a fixed number of shares at a specified price at some time in the future.

Share options have been traded for centuries but their use expanded significantly with the creation of traded option markets in Chicago, Amsterdam and, in 1978, the London Traded Options Market. In 1992 this became part of the London International Financial Futures and Options Exchange (LIFFE - pronounced 'life'). Euronext bought LIFFE in 2002 and it is now officially Euronext liffe.

A share call option gives the purchaser a right, but not the obligation, to buy a fixed number of shares at a specified price at some time in the future. In the case of traded options on LIFFE, one option contract generally relates to a quantity of 1,000 shares. The seller of the option, who receives the premium, is referred to as the writer. The writer of a call option is obliged to sell the agreed quantity of shares at the agreed price sometime in the future. For options traded in US can be exercised by the buyer at any time up to the expiry date, whereas options traded in Europe can only be exercised on a predetermined future date. Just to confuse everybody, the distinction has nothing to do with geography: most options traded in Europe are American-style options.

Call Option Holders (Call Option Buyers)

The option premiums vary in proportion to the length of time over which the option is exercisable.

Now let us examine the call options available on an underlying share, Cadbury Schweppes, on 31 October 2002. There are a number of different options available for this share, many of which are not reported in the table presented in the Financial Times, which is reproduced as Exhibit 1.1.

So, what do the figures mean? If you wished on 31 October to obtain the right to buy 1,000 shares on or before late January 2003 at an exercise price of 420p, you would pay a premium of £245 (1,000 X 24.5p). If you wished to keep your option to purchase open for another 3 months you could select the April call. But this right to insist that the writer sells the shares at the fixed price of 420p on or before a date in late April will cost another £80 (the total premium payable on one option contract is £325 rather than £245). This extra £80 represents additional time value. Time value arises because of the potential for the market price of the underlying to change in a way that creates intrinsic value. The intrinsic value of an option is the payoff that would be received if the underlying were at its current level when the option expires. In this case, there is currently (31 October) no intrinsic value because the right to buy is at 420p whereas the share price is 416p. However, if you look at the call option with an exercise price of 390p then the right to buy at 390p has intrinsic value because if you purchased at 390p by exercising the option you could immediately sell at 416p in the share market: the intrinsic value is therefore 26p per share, or £260 for 1,000 shares. The longer the time over which the option is exercisable, the greater the chance that the price will move to give intrinsic value. Time value is the amount by which the option premium exceeds the intrinsic value.

The two exercise price (also called strike price) levels presented in Exhibit 1.1 illustrate an in-the-money option (the 390 call option) and an out-of-the-money option (the 420 call option). The underlying share price (416p) is above the strike price of 390 and so the 390p call option has an intrinsic value of 26p and is therefore in-the-money. The right to buy at 420p is out-of-the-money because the share price is below the call option exercise price and therefore has no intrinsic value. The holder of a 420p option would not exercise this right to buy at 420p because the shares can be bought on the stock exchange for 416p. (It is sometimes possible to buy an at-the-money option, which is one where the market share price is equal to the option exercise price.)

To emphasize the key points: The option premiums vary in proportion to the length of time over which the option is exercisable (e.g. they are higher for an April option than for an January option). Also, call options with a lower exercise prices will have a higher premiums.

Suppose on 31 October you are confident that Cadbury Schweppes shares are going to rise significantly over the next 3 months to 700p and you purchase a January 390 call at 41.5p.2 The cost of this right to purchase 1,000 shares is £415 (41.5p X 1,000 shares). If the share rises as expected then you could exercise the right to purchase the shares for a total of £3,900 and then sell them in the market for £7,000. A profit of £3,100 less the option premium of £415 (i.e. £2,685) is made before transaction costs (the brokers' fees, ete. would be in the region of £20-£50). This represents a massive 647 per cent rise before costs.

However, the future is uncertain and the share price may not rise as expected. Let us consider two other possibilities. First, the share price may remain at 416p throughout the life of the option. Second, the stock market may have a severe downturn and Cadbury Schweppes shares may fall to 300p. These possibilities are shown in Exhibit 1.2.